Twists and Turns in the Yield Curve

An inverted yield curve is usually an ominous sign of impending recession -- but maybe not this time.

Well, it happened on Tuesday -- the yield curve inverted. Specifically, the two-year U.S. Treasury's yield of 4.347% pushed higher than the 10-year U.S. Treasury's yield of 4.343%. And the inversion seemed to spook the markets -- the Dow fell 105 points to 10,777.77, and the Nasdaq dropped 22 points to 2,226.89. (For current interest rates, click here.)

Why the concern over an inverted yield curve? Let's start with the basics. The yield curve is essentially a chart that shows the difference between short-term and long-term interest rates. Typically, the chart -- the curve -- slopes upward, with short-term (e.g., three-month or two-year) rates lower than long-term (e.g., 10-year) rates. Investors usually demand higher rates to lend their money for long-term periods because of the increased risk that inflation will reappear while their money is tied up.

With that out of the way, here's the reason for the fuss: The last time short- and long-term rates inverted, back in 2000, it was followed by a recession -- if "recession" is defined as two consecutive quarterly declines in real gross domestic product. In fact, an inverted yield curve has preceded all six recessions since 1970. Granted, most of these inversions lasted at least a few weeks, so yesterday's one-day inversion is not too serious. But it is something to keep an eye on.

An inverted yield curve usually results because the Federal Reserve raises short-term interest rates so much that investors begin to worry that loan demand will decline and economic growth will stall. One could argue that the Fed's persistent and seemingly endless drive to raise short-term interest rates -- it has increased the rate 13 times over the past 18 months -- is likely to cause a recession. While the Fed certainly wants a "soft landing" (i.e., sustainable economic growth without inflation), this is never easy to accomplish, and sometimes the attempt overshoots. When it does, the economy slows down too much. Yesterday's inverted yield curve may therefore signal that the Fed has tightened too much.

But economic indicators, including the yield curve, are never perfect. In fact, according to New York Fed economist Arturo Estrella, the yield curve inverted in 1967 (link opens a PDF file) without a recession occurring afterwards. Furthermore, there were extremely flat yield curves in 1995 and 1998 (albeit not inverted) that were false recessionary signals; the economy subsequently continued to grow both times. Thus, an argument can be made that an inversion does not necessarily portend a recession -- indeed, things might be different this time.

Consider this: James Berman, a money manager and adjunct professor of finance at New York University, believes that long-term interest rates are low because of supply-and-demand considerations unrelated to concerns about an economic slowdown. "The inverted yield curve is most likely the result of heavy buying of our long-term U.S. Treasuries by the Chinese in order to peg their currency, the yuan, to the dollar," he says. "By buying huge amounts of our bonds, the Chinese cause a distortion in yield that has, in turn, kept bond yields artificially low and fueled the housing boom by keeping mortgage rates down."

Even Fed Chairman Alan Greenspan is skeptical of the dangers of an inverted yield curve. In his July testimony before Congress, he indicated that low long-term rates may indicate increased investor confidence in stable prices and in a moderation in the business cycle, both of which would augur for stronger economic growth, not weaker.

What's more, corporate America has solid balance sheets and appears to be fairly confident that the economic good times will continue -- as seen by the spate of merger-and-acquisition activity lately. And if the economy does slow down, it might primarily affect only the sectors that have arguably grown too fast and need to rest, such as real estate.

Most Wall Street analysts value stocks based on a discounted-cash-flow analysis and use the interest rate on 10-year U.S. Treasuries as a key component in calculating the discount rate. The lower this rate is, the more valuable a company's cash flows become. Interestingly enough, therefore, an inverted yield curve may be a positive for equities, not a negative, and investors may become more interested in equities, which have lagged other asset classes (e.g., commodities) over the past few years. But given the impressive track record of inverted yield curves forecasting recessions, I wouldn't bet on it.